Modelling corporate bonds: considerations for stochastic modelling

Document description

Many of the newly issued corporate bonds are finding their way into insurance and pension fund asset portfolios. Modelling these bonds is tricky. Historic return distributions are well behaved and the observed credit spreads exceed all estimates of historic default probabilities. As a result, corporate bonds may appear anomalously attractive. We show that some of the more widely used models of corporate bonds have some major weaknesses from a theoretical perspective and in particular fail to explain this apparent anomaly convincingly. However, our analysis of the economics of corporate debt early in the paper suggests that credit spreads are option premiums and thus have option-like characteristics. This leads to the Merton Model as a means of capturing these characteristics. The model reveals that the apparent anomaly in credit spreads is another facet of well known apparent anomalies in option prices under the standard Black Scholes Model (such as the existence of skews and smiles in implied volatility). The latter anomalies are not generally regarded as exploitable in asset allocation studies.